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FINANCIAL LIBERALISATION AND THE RELATIONSHIP
BETWEEN FINANCE AND GROWTH

Introduction
1The relationship between financial development and economic growth has received a great
deal of attention throughout the modern history of economics. Its roots can be traced in Lydia
of Asia Minor where the first money was in evidence. The first signs of public debate,
however, on the relationship between finance and growth, and indeed on experiments with free
banking, can be located in Rome in the year 33 AD. In that year there was probably the first
classic case of public panic and run on the banks. The Romans debated intensely and fiercely
at that time the possibility of placing a hitherto free banking system under the control of the
government. Since then, of course, a great number of economists have dealt with the issue.
An early and intellectual development came from Bagehot (1873), in his classic Lombard
Street, where he emphasised the critical importance of the banking system in economic growth
and highlighted circumstances when banks could actively spur innovation and future growth
by identifying and funding productive investments. The work of Schumpeter (1911) should
also be mentioned. He argued that financial services are paramount in promoting economic
growth. In this view production requires credit to materialise, and one "can only become an
entrepreneur by previously becoming a debtor.....What [the entrepreneur] first wants is credit.
Before he requires any goods whatever, he requires purchasing power. He is the typical debtor
in capitalist society" (p. 102). In this process, the banker is the key agent. Schumpeter (1911)
is very explicit on this score: "The banker, therefore, is not so much primarily the middleman
in the commodity `purchasing power' as a producer of this commodity ..... He is the ephor of
the exchange economy" (p. 74).

Keynes (1930), in his A Treatise on Money, also argued for the importance of the banking
sector in economic growth. He suggested that bank credit "is the pavement along which

can be considered as an antidote to the thesis put forward by Modigliani and Miller (1958)
that the way firms finance themselves is irrelevant (their `irrelevance propositions'), which is
consistent with the perception of financial markets as independent entities from the rest of the
economy, so that finance and growth are unrelated. Despite severe doubts on the relevance of
the Modigliani and Miller (op. cit.) theorem, some economists still would argue that finance
and growth are unrelated. A good example of this view is Lucas (1988) who argues that
economists `badly over-stress' the role of the financial system, thereby reinforcing the
difficulties of agreeing on the link and its direction between finance and growth.

This paper aims to explore the issues of the relationship between financial development and
growth from the perspective of evaluation of the effects of financial liberalization. Since the
focus is on financial liberalization, a short review of certain related issues is in order. It used to
be that banking, with banks as the first major lenders, along with rights of private ownership of
investment, led to control of real investment by bank lenders. In many parts of today’s world
only government and banks direct much of the real investment.
2
Projects live or die by bank
decision as to willingness to finance. In the G7 nations, however, in addition to government
and banking, investment is directed by managers of retirement funds (both public and private),
insurance companies investing their reserves, along with many other financial institutions with
accumulated reserves. Individuals via their self directed pension and retirement funds, do not
have much impact in this; individuals place money with financial institutions who in turn place
the money as they think fit. This institutional framework has been facilitated by various pieces
of accumulated legislation, such as those creating tax-deferred retirement accounts, and tax-
deferred insurance reserves, along with many others. The result is a variety of professional
managers responsible for facilitating real investment whose performance is measured by
institutionally determined financial standards. So now there is a combination of public,
commercial and managerial institutions, directing real investment, each with its own set of
financial objectives, and which can be competing and/or operating at cross purposes. Failing to
recognize that positive financial outcomes are not necessarily positive real outcomes has

central banks, especially in developing countries, a fairly common practice in the 1950s and
1960s, which was challenged by Goldsmith (1969) in the late 1960s, and by McKinnon (1973)
and Shaw (1973) in the early 1970s. They ascribed the poor performance of investment and
growth in developing countries to interest rate ceilings, high reserve requirements and
quantitative restrictions in the credit allocation mechanism. These restrictions were sources of
`financial repression', the main symptoms of which were low savings, credit rationing and low
investment. They propounded instead the thesis which has come to be known as `financial
liberalisation', which can be succinctly summarised as amounting to ‘freeing’ financial markets
from any intervention and letting the market determine the allocation of credit.
3However, left out of consideration were other policy options selected by government that
preceded these policies; for example, the general case was that of various combinations of
foreign fixed exchange rates and governments incurring debt in external currencies. Many of
the financial restrictions subsequently imposed were designed to help sustain the exchange rate
regime and support the external debt. This combination obviated otherwise available
government policy responses (such as government deficit spending of local currency) to
support investment and consumption at full employment levels. Instead, financial liberalization
was proposed in the context of fixed exchange rates and external debt. It should, thus, have
been no surprise that a variety of currency and banking crises followed the attempts at
financial liberalization (see, for example, Arestis and Glickman, 2002).

One might qualify
straightaway by suggesting that this analysis is conducted under given institutional structure as
mandated by government, and that policy options can be selected that inhibit investment. With
direct government investment always an option, and accounting that recognizes government
investment as such, government can always alleviate lack of investment, although typically it
would be a different form of investment. It is, thus, true that government can ‘allow’ markets
to direct real investment. The history of banking, however, as the policy makers in both

),
the frequency and scale of crises have, on the whole, been lower than in the developing world.

The second important finding is that beyond the financial costs of banking crises for the local
economies involved, they exacerbate downturns in economic activity, thereby imposing
substantial real economic costs. Banks in developing countries hold the lion's share of financial
assets, meaning that they are the main holders of shares, etc., operate the payments system,
provide liquidity to financial markets, and are major purchasers of government bonds. In
addition, bank liabilities have been growing much faster in developing countries over the past
two decades than economic activity. Moreover, the increasing weight and integration of
developing and emerging economies in international financial markets have resulted in
spillover effects to industrialised countries. There is, thus, an increased risk that banking crises
in developing economies will have unfavourable repercussions on industrial countries. A very
disturbing aspect of the crises discussed in this section is that they spill over to the real
economy where real output and investment are lost. This is exacerbated by the fact that the
latter are not accompanied by appropriate policy responses to sustain aggregate demand,
output and employment, when the exposure to which we have just referred materialises.
Governments could have allowed real output to be sustained in spite of bank ‘financial’
difficulties, and in spite of losses by shareholders, lenders, etc. In fact, governments have
allowed banking crises to alter the ‘quantity’ of new investment and real output, when those
governments have had the option all along to allow growth to continue. More seriously,
though, is the cost in terms of real output resulted from these crises. Table 1 makes the point
very well. Such loss in many countries was staggering, reaching over 60 per cent in some
cases, followed by substantially reduced output and employment.

We wish to argue that this experience is not unrelated to the financial liberalisation policies
pursued by countries, which adopted the principles of the thesis in the context of their existing
institutional structure. This we do by looking at a number of problems entailed in the thesis
and at the evidence that can be adduced. We begin with a brief summary of the main
propositions of the financial liberalisation thesis before we turn our attention to its problematic

The policy implications of this analysis are quite straightforward: remove interest rate ceilings,
reduce reserve requirements and abolish directed credit programmes. In short, liberalise
financial markets and let the free market determine the allocation of credit, where it is assumed
that there will be a ‘free market’ with just a few banks, thereby ignoring issues of oligopoly
and, of course, of credit rationing type of problems as in Stiglitz and Weiss (1981). With the
real rate of interest adjusting to its equilibrium level, at which savings and investment are
assumed to be in balance, low yielding investment projects would be eliminated, so that the
overall efficiency of investment would be enhanced. Also, as the real rate of interest increases,
saving and the total real supply of credit increase, which induce a higher volume of investment.
Economic growth would, therefore, be stimulated not only through the increased investment
but also due to an increase in the average productivity of capital. Moreover, the effects of
lower reserve requirements reinforce the effects of higher saving on the supply of bank
lending, whilst the abolition of directed credit programmes would lead to an even more
efficient allocation of credit thereby stimulating further the average productivity of capital.

Even though the financial liberalisation thesis encountered increasing scepticism over the
years, it nevertheless had a relatively early impact on development policy through the work of
the IMF and the World Bank who, perhaps in their traditional role as promoters of what were
claimed to be free market conditions, were keen to encourage financial liberalisation policies in
developing countries as part of more general reforms or stabilisation programmes. When
events following the implementation of financial liberalisation prescriptions did not confirm
their theoretical premises, there occurred a revision of the main tenets of the thesis.

Initially,
the response of the proponents of the financial liberalisation thesis was to argue that where
liberalisation failed it was because of the existence of implicit or explicit deposit insurance
coupled with inadequate banking supervision and macroeconomic instability (for example,
McKinnon, 1988a, 1988b; 1991; Villanueva and Mirakhor, 1990; World Bank, 1989). Those
conditions were conducive to excessive risk-taking by the banks, which can lead to `too high'
real interest rates, bankruptcies of firms and bank failures. That led to the introduction of new

when borrowers net worth is reduced by negative shocks, such as recessions and losses due to
terms of trade (see, also, World Bank, 1989). Caprio et. al. (1994) reviewed the financial
reforms in a number of primarily developing countries and concluded that managing the
reform process rather than adopting a laissez-faire approach was important, and that
sequencing along with the initial conditions in finance and macroeconomic stability were
critical elements in implementing successfully financial reforms. All these modifications,
however, indicate that there is no doubt that the proponents of the financial liberalisation
thesis do not even contemplate abandoning it. No amount of revision has changed the
objective of the thesis, which is to pursue the optimal path to financial liberalisation, free from
any political, i.e. state, intervention.

Still another financial liberalization development is related to the emergence of the ‘new
growth’ theory (i.e. the endogenous growth model). This development incorporates the role of
financial factors within the framework of new growth theory, with financial intermediation
considered as an endogenous process. A two-way causal relationship between financial
intermediation and growth is thought to exist. The growth process encourages higher
participation in the financial markets, thereby facilitating the establishment and promotion of
financial intermediaries. The latter enable a more efficient allocation of funds for investment
projects, which promote investment itself and enhance growth (Greenwood and Jovanovic,
1990). Furthermore, in such models financial development can affect growth not only by
raising the saving rate but also by raising the amount of saving funneled to investment and/or
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raising the social marginal productivity of capital. With few exceptions (for example, Easterly,
1993) the endogenous growth literature views government intervention in the financial system
as distortionary and predicts that it has a negative effect on the equilibrium growth rate.
Increasing taxes on financial intermediaries is seen as equivalent to taxes on innovative
activity, which lowers the equilibrium growth rate. Imposing credit ceilings reduces individual

1999). The financial services view attempts to minimise the importance of the distinction
between bank-based and market-based financial systems. It is financial services themselves that
are by far more important, than the form of their delivery. In the financial services view, the
issue is not the source of finance. It is rather the creation of an environment where financial
services are soundly and efficiently provided. The emphasis is on the creation of better
functioning banks and markets rather than on the type of financial structure. The evidence
produced to support this view is based on panel and cross-section studies, and demonstrates
that financial structure is irrelevant to economic growth. However, these multi-country studies
are also subject to a number of concerns, summarized in Arestis et al. (2004). Using time
series and accounting for heterogeneity of coefficients across countries, it is demonstrated in
Arestis et al. (op. cit.) that ‘financial structure does matter’. The finance and law view
9
maintains that the role of the legal system in creating a growth-promoting financial sector,
with legal rights and enforcement mechanisms, facilitates both markets and intermediaries. It
is, thereby, argued that this is by far a better way of studying financial systems rather than
concentrating on bank-based or market-based systems. This view, however, does not quite
accord with the facts. For it is the case that while the degree of financial development has
changed over the last 100 years or so, legal origins in each country have not changed by
muchand by the frequency that the degree of financial development has changed.

We wish to argue in the rest of this paper that there are a number of issues in these arguments,
which are critical in the development of the financial liberalisation thesis. We argue that these
propositions are not problem-free. They are, in fact, so problematic that they leave the thesis
without serious theoretical and empirical foundations.

Problems with Financial Liberalisation


liberalisation had taken place before financial liberalisation, not much success can be reported
(Lal, 1987). The opposite is also true, namely that in those cases, like Uraguay, where the
`reverse' sequencing took place, financial liberalisation before trade liberalisation, the
experience was very much the same as in Chile (Grabel, 1995).

Stiglitz (2000) highlights difficulties with the sequencing literature in explaining the South East
Asian crisis. South East Asian countries had very strong macroeconomic fundamentals, along
with sound systems of banking regulation and supervision. So that reasonable economic
policies and sound financial institutions were in place; high growth rates for long periods with
low inflation rates were also evident. Still the South East Asian financial crisis of 1997-1998